ABA, Section of International Law and Practice1993 New York Annual MeetingPreparing and Implementing Financial Law inEmerging Markets: Eastern Europe, the FormerSoviet Union and the Developing WorldAugust 10, 1993

DEVELOPING THE POLISH SECURITIES MARKET

by

Robert D. Strahota*Office of General Counsel

U.S. Securities and Exchange Commission

* The U.S. Securities and Exchange Commission, asa matter of policy, disclaims responsibility forany private publication prepared by any of itsemployees. The views expressed herein are those ofthe author and do not necessarily reflect the viewsof the Commission or of the author's colleaguesupon the staff of the Commission.

I. Introduction and Market Overview II

In just over two years, Poland hassuccessfully implemented a very sound and workablesystem of securities regulation. The centerpieceof this system is the Act on Public Trading inSecurities and Trust Funds (the "Act"). Followingthe adoption of the Act in March 1991, the PSC wasorganized and the WSE reopened after a 52-yearhiatus.

As of May 1993, there were 18 issues of equitysecurities listed on the WSE. One and three-yeargovernment bonds, each with several series, arealso listed. Equities and government bonds aretraded Mondays, Tuesdays and Thursdays, except thatone equity listing is traded only on Thursqays asa second tier listing. ~I In other respects, firstand second tier trading procedures are essentially

II In June 1993, the author completed a one-yearassignment in Warsaw as the U.S. Securities andExchange Commission ("SEC") Senior Adviser to thePolish Securities Commission ("PSC"). Thisplacement was made under the SEC's technicalassistance program for Central and Eastern Europe,which is funded by the U.S. Agency forInternational Development. Portions of thematerial included in this paper have beenexcerpted from the author's Report andRecommendations delivered to the PSC and WarsawStock Exchange ("WSE" ).•~I There is also a separate daily tradingprocedure for large blocks of government bonds.Other government bonds are traded in off-exchangemarkets.

the same. There is a designated specialist for

each issue. Only one trading price per issue per

session is established by optimum matching of buy

and sell orders. Prices are subject to a limit on

increases and decreases of not more than 10% from

the previous session's price. Generally, the size

of all orders may be reduced downward, except that

small orders of thi rty shares or less may be

specified as all or none orders. If the rate ofexecution would be less than 20%, transactions may

not be executed due to too great a market

imbalance.

At present there is only one domestic

investment fund operating in the Polish ma rke t .

Pioneer First Polish Trust Fund is organized as an.open-end trust fund under the European UCITS model.

Following a reduction in interest rates, there

have been substantial increases in WSE volume andshare prices during the first five months of 1993. J/

Both domestic and foreign investors have shown

increased interest in the market.

~/ The WIG (market index) increased nearly 190%from December 31, 1992 through May 20, 1993. Mostissues were trading at all time highs and sessionvolume reached a record 346 billion zloties(approximately $20 million) on May 20th. During1992, the average monthly volume was under 200billion zloties.

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II. Regulatory StructurePSC. Two factors significantly distinguish

the PSC from the U.S. SEC model. First, the PSChas substantially less independence than the SEC. !/

Second, the PSC's statutory mandate is

substantially broader than the SEC's mandate in theareas of market development and capital marketseducation . .2/

One of the PSC' s principal regulatoryobjectives is conforming the Polish securities

!/ Under the Securities Exchange Act of 1934, theSEC is organized as an independent regulatorycommission with five commissioners appointed bythe President and confirmed by the Senate forstaggered five-year terms. Commissioners may nothave outside employment and no more than threecommissioners may be appointed from the samepolitical party. In contrast, PSC members serveat the will of the Polish government. The PSCmembership currently includes, in addition to aChairman appointed by the Prime Minister at therequest of the Minister of Finance and Presidentof the National Bank of Poland, two vice chairmanappointed by Prime Minister at the request of thePSC Chairman, individual representatives appointedby the Minister of Finance, Minister of OwnershipTransformations (Privatization), President of theNational Bank and President of the Anti-MonopolyOffice, and individual members nominated by theWSE and an association of individual brokers.~/ Under Article 7 of the Act, the PSC isdirected to cooperate with governmentadministrative bodies, the National Bank ofPoland, securities market institutions, andparticipants in public trading in designing stateeconomic policy with a view to promoting thedevelopment of the securities market. Also thePSC is directed to disseminate knowledge of theprinciples governing the operation of thesecurities market.

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regulation model to European Community ("EC")

Directives so that Poland may achieve its goal of

associate, and eventually full, membership in the

EC. The PSC has made significant progress towardthis goal.

WSE. The WSE is organized as a nonprofitmembership corporation. Q/ As a licensed exchange

under the Act, its rules and regulations are

subject to approval of the PSC. One of the most

significant advantages of trading on the WSE is

its book entry system for clearance and settlement.

All securities are traded on a dematerialized basis

without transfer of physical certificates.

Depositary and clearance and settlement functions

are carried out by the National Depositary of

Securi ties ("National Depositary"). The National

Depositary is currently a division of the WSE, but

under the PSC's proposed amendments to the Act, it

would become a separate legal entity owned by its

members.

In the next few years, the WSE will face a

number of important structural decisions. First,

Q/ Although the WSE has 23 members, over 90% ofthe ownership still belongs to the Polishgovernment represented by the Ministry ofPrivatization. Steps have recently been taken togive WSE members more voice in corporategovernance.

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changing to a daily trading system with continuouspricing will require a new trading model andreconsideration of current trading rules, includingthe role of specialists and price limits. Second,now that the mass privatization program ("MPP") hasbecome law, the WSE and National Depositary will beexpected to accommodate dematerialized trading ininvestment certificates and shares of over 20National Investment Funds ("NIFs") in volumessubstantially in excess of the current level oftrading. Finally, the WSE may face competitionfrom over-the-counter ("OTC") markets.III. Law Reform

Recommendations by the SEC Adviser and othersecurities law experts were taken intoconsideration by the PSC staff in drafting proposedamendments to the Act. These amendments wouldimprove the Act in a number of areas, including:

* Prospectus delivery requirements.* Issuer reporting and continuous

disclosure obligations.* Authority to grant exemptions.* Examination and investigatory authority.* Simplification of takeover provisions.* A brokerage firm self-regulatory

organization.

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* Provisions regarding closed-end funds.

* Brokerage firm reporting.

* More flexible remedies.

* Independence of the National Depositary.IV. Market Development Issues

Is the market overregulated? Because there

are few issues of stock listed on the WSE and the

market capitalization represents only a small

portion of Poland's Gnp, some critics have

suggested that the market must be overregulated.

This criticism overlooks: (i) the important role of

securities regulation in promoting capital

formation and economic growth; (ii) the fact that

securities regulation is only one of many factors

necessary to foster the growth of securities,

markets; 1/ and (iii) the difficulties inherent in

attempting to accelerate the growth of securities

markets by altering the interaction of marketforces which traditionally determine how and when

companies are selected as candidates for public

share ownership.

A sound regulatory infrastructure of

securities, banking and other commercial laws is

1/ Factors such as a tax policy which encouragesinvestment and capital. turnover, and macroeconomicpolicies which stimulate savings and investment,are beyond the scope of this paper.

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essential for the development of securitiesmarkets. If investors are not given reliableinformation, or if they do not believe that asecurities market is a fair market, free ofmanipulation, they are likely to look elsewhere forinvestment opportunities. What the PSC and WSEhave accomplished in just over two years is to putin place a basic securities market infrastructureso that investors now are beginning to invest inpublicly-traded Polish securities based upon theinvestment merits of these issues.

It is important, however, to go beyond thegeneral question of overregulation and considerwhether there are specific requirements thatunnecessarily restrict capital formation, forexample, by limiting the number of brokerage fir~sor issuers participating in the market.

Number of Brokers. As of May 1993, there were29 licensed brokerage firms, and 331 individualbrokers who have passed the brokers' examination.However, not all persons working for brokeragefirms are required to be licensed brokers and themajority of persons who receive customer orders arenot licensed. The PSC's approach probably hasenabled brokerage firms to begin operations anddevelop a customer base more quickly than if all

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persons engaging in securities activities had been

required to be licensed by passing an examination.

Because market opportunities for financial

intermediaries are limited by the small number ofissuers, it is doubtful that market development has

been 1imited by the current number of 1icensed

brokerage firms and individual brokers. However,

this situation could change in the near future in

light of the MPP and other securities issues likely

to increase market size, profit potential and thedemand for financial intermediary services.

Number of Issuers. The more interestingquestion is why are there only 18 publicly-traded

issuers? The most likely immediate source of

publicly-traded issuers would appear to be

privatization of state enterprises through share

issuance. However, the Ministry of Privatization

has privatized very few companies in this manner.

Privatization through share issuance actually came

to a standstill in 1992, but it has improved during

1993. Statements by WSE and Ministry of

Privatization representatives suggest that there

could be 25-30 listed issues by the end of 1993.

Two factors which may have limited the numberof privatizations through share issuance include:

(i) the availability of strategic or other

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institutional investors compared to the difficultyof finding public investors with capital topurchase underwritten share offerings on a

consistent basis, and (ii) the relatively low levelof price/earnings ratios of WSE issuers until thisyear's market uptrend.

Upon analysis, listing and disclosure andreporting requirements appear not to present theregulatory burdens that some critics havesuggested. ~/

Sources of Publicly-Traded Issuers. Severalpotential sources are likely to increase the numberof public-traded issuers in the Polish market: (i)small business issuers that grow and need to accessthe public market for additional capital; (ij) theMPP NIFs, and state enterprises in NIF investment

~/ The WSE has recently reduced its listingrequirements for second tier listings so that nowa market capitalization of only 5 billion zloty(about $300,000) and only one year of auditedfinancial statements are required. The first tierrequirements are a market capitalization of 20billion zloty (about $1,200,OOO) and three years'financial statements. Moreover, the 1991 Act onExamination and Disclosure of Financial Reports,and Auditors and their Self-Government, which isbased upon an EC model, provides for a four-yearphase-in period for the development of a Polishauditing profession. Commencing with the 1992accounting year, this act requires joint stockcompanies, banks, state enterprises and certainother entities to present audited financialreports unless, in the case of banks and stateenterprises, the Minister of Finance has exemptedthem from such requirements.

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portfolios which may be offered publicly as one of

several NIF liquidation strategies; and (iii) other

issuers' securities that may soon become traded in

secondary markets. ~/Public offerings by small business issuers,

may eventually provide the most promising source of

new publicly-traded issuers. One of the most

positive signs in the Polish economy is that almost

1.7 million private enterprises are currently

registered, offering jobs to about 3.6 million

persons. The share of the private sector in the

total GDP is now over 40%. However, it is

impossible to predict when and how many of these

small businesses may eventually grow, raise capital

in the public markets, and become publicly-traded.

u.S. experience suggests that the process takes

time and is not easily accelerated. 10/ It also

~/ These secondary markets may develop: (A) amongcreditors and other investors in shares issued inexchange for enterprise indebtedness under the Lawon Financial Restructuring of Enterprises andBanks; (B) among employees in shares issued toemployees of state enterprises under the proposedState Enterprise Covenant; and (C) among employeesand NIFs under the MPP.

10/ The U.S. market for publicly-traded issuers isthe world's largest, but it has taken many yearsof additions of public companies and growth inmarket valuation to reach its current size. Over95% of all U.S. private business units are notowned by public shareholders. Generally, only themost promising companies are good candidates for

(continued ...)

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suggests two important points regarding the effectof securities regulation on small businessfinancing and growth. First, there must be a

sufficient exemption for nonpublic offerings of

securi ties so that financing can be provided to

small businesses without unnecessary regulatory

burdens. Second, the Act should permit licensedbrokerage firms to become involved in small

business financing activities. 11/

v. Summary of Recommendations

The SEC Adviser's report included

recommendations in the following areas.

Act's Coverage; General Fraud Prohibition.

Poland has chosen to focus its system of

securities regulation on activities related to the

public trading of securities. There are certain

dangers inherent in limiting the regulatory

umbrella to this island of acti vity. The Act's

coverage should be broadened to give the PSC

authority to prevent fraudulent securities

lO/( ...continued)public offerings. Several rounds of venturecapital or seed financing are often requiredbefore a company is ready for public offering.

11/ The Act already includes a liberal nonpublicoffering exemption. The proposed amendments wouldalso exempt certain offerings to existingshareholders, and would permit licensed brokeragefirms to engage in exempt financing activities.

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activities, public or private, by licensed orunlicensed financialpersons.

intermediaries or other

Rulemaking Authority. As the agency with thetechnical expertise in securities regulation, thePSC should have more authority to adopt regulationsnecessary to implement the Act in technical areas,such as prospectus disclosure requirements andinsider trading.

Brokerage Firms, Brokers and InvestmentAdvisers. The current licensing regime which thePSC administers for brokerage firms and ind;vidualbrokers has worked well for purposes of getting themarket started. Several changes should beconsidered as the securities markets grow anddevelop. These include: (i) expanding the range ofpermissible activities for licensed brokeragefirms; (ii) providing an exemption from investmentadviser requirements for certain activities oflicensed brokers and focusing examinationrequirements more on legal and ethicalconsiderations instead of academic theory; 12/(iii) licensing by examination of all brokeragefirm personnel engaging in securities activities

12/ There are currently no licensed investmentadvisers. The first examination will be givenlater this year.

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but with different, in some cases less rigorous

standards, depending upon the scope of an

individual's securities activities; and (iv) PSC

moni toring of the number of brokerage firms and

broker participants to consider whether the current

firm capital and individual broker examination

requirements should be relaxed. 13/

Self-Regulation. Self-regulation is designed

to minimize direct governmental involvement and

costs of regulation by permitting industry

participants to develop standards of conduct which

are legal, fair and ethical. The PSC's proposed

amendments to the Act provide that entities

operating brokerage firms may associate in a

commercial chamber. To make self-regulation work>

effectively, all firms should be required to join

the association and the PSC should have authority

13/ The PSC's current capital requirement is 2.5billion zloties (approximately $150,000) for firmsengaging in dealer activities. Effective December31, 1993, the WSE proposes to make its capitalrequirement 3 billion zloties for member firmsengaging in dealer activities. For comparisonpurposes, SEC requirements were recently raised to$250,000 for firms carrying customer accounts orholding customer funds or securities. U.S.capital to indebtedness of requirements are nomore than 8-to-l for the first twelve months ofoperations, and 15-to-l thereafter, whereas thecurrent Polish requirement is roughly a 3-to-lleverage factor. It is understood that the PSCplans to reconsider its current capital toindebtedness requirements.

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to approve and require changes in the association'srules.

WSE and National Depositary. Because the WSE

and National Depositary have responsibi 1ities totheir members, listed issuers and increasing

numbers of public investors, they should have the

benefit of the highest quality advice fromindependent sources as they undertake the

transition to a more active market place offering

continuous daily trading.

Exchange and aTC Markets. Some basic rules

are necessary to cause brokerage firms

participating in such markets to act responsibly,

to enable investors and others to assess the value

of the securities traded and to provid~ for

efficient clearance and settlement procedures.

Bank Securities Activities. Most of the

licensed brokerage firms are bank-affiliated, 14/but the PSC does not currently require that the

bank brokerage units be separate legal entities.

This presents difficult examination and reportingproblems from a regulatory standpoint. The PSC

recognizes this issue and it should address it in

14/ Twenty-one of the 29 licensed brokerage firmsare bank-affiliated, including 20 of the 23 WSEmembers and 7 of the 8 specialist firms. It isestimated that over 90% of customer accounts aremaintained with bank brokerage units.

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coordination with banking regulators with the

objective of regulating of bank and nonbank

brokerage firms on a level playing field.

Extension of Credit. The PSC should work with

banking authorities to develop a law that regulates

extension of credit in securities transactions by

banks and others.

Underwriting and Distribution Practices. The

PSC should convene a small working group of U.S.

advisers to meet with their Polish counterparts and

PSC and WSE representatives to make recommendations

for improving Polish underwriting and distribution

practices, including elimination of the currentdelay of over a month between completion of

underwriting and listing of securities.Financial Reporting and Disclosure. Annual

reporting requirements for publicly-traded issuers

are adversely affected by certain requirements in

the Polish Commercial Code that delay release of

audited financial statements. The private sector

accounting profession, the PSC and the WSE shouldhave more involvement in the establishment of

financial reporting standards.

Enforcement and Remedies. The PSC should

place more emphasis on civil and administrative

remedies.

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ROBERT D. STRAHOTAIn June 1993, Mr. Strahota completed a one-year assignment

as U.S. Securities and Exchange Commission Senior Adviser to thePolish Securities Commission. During 1991-92, he was anAttorney-Fellow in the SEC's Office of General Counsel,specializing in international technical assistance matters. Mr.Strahota's professional experience includes 19 years of privatepractice with the law firm of Kirkland & Ellis, where hespecialized in securities, corporate and partnership law, andeight years in the SEC's Division of Corporation Finance. Hereceived B.A. and M.B.A. degrees from Cornell University and aJ.D. degree from The Catholic University of America School ofLaw. Mr. Strahota is a member of the District of Columbia Barand the ABA Section of Business Law.